Arcane Topics in Economics and Philosophy, Interspersed with Various Distractions

April 01, 2008

Free Banking

Alvaro Vargas Llosa advocates one of the battiest, or perhaps the most brilliant, libertarian ideas, the abolition of the Federal Reserve ("Government Solving Its Own Crises", TCS Daily, 24 Mar 2008):

The Federal Reserve recently announced new measures to tackle the current financial crisis. They include helping J.P. Morgan Chase acquire Bear Stearns, lowering the discount rate and offering short-term loans to about 20 investment banks-- and they came only days after the government said it would inject $200 billion into the financial system.

These are the latest steps taken by the U.S. government to solve a problem created in large measure by the government itself. We have seen this movie before. As a reaction to the bursting of the dot-com and telecom bubbles at the end of the 1990s, the Fed inflated the currency through the actions of its Open Market Committee. By June 2003, the policy of easy money was reflected in the drop of the federal funds rate to 1 percent. The loose monetary policy was maintained, with variations, for almost five years. The result was a fiction economy in which millions of people borrowed and consumed too much. The fact that mortgage loans were turned into sophisticated securities traded internationally made the fiction global.

And what's wrong with that? Who's to say that people borrowed and consumed "too much?" Isn't consuming more better than consuming less? Unless it leads to catastrophe. But it hasn't, yet-- no, a financial crisis that has had very little effect on the real economy so far doesn't qualify.

Greedy investors and profligate consumers are but a symptom of the real problem, which is monetary policy. The history of the boom-bust cycle since the creation of the Federal Reserve in 1913 has been the deliberate increase of the money supply, the misallocation of resources due to the perverse incentives of inflation, and eventually the bursting of the bubble. It is the consequence of the Federal Reserve system, a central bank that confers upon a chosen elite -- the Federal Reserve governors -- the monopoly of money creation and the power to decide what amount of money is appropriate for an economy in which millions of people are making decisions they cannot anticipate.

The Fed was created as a response to the periodic bank runs of the late 19th and early 20th centuries. Some of the greatest economists have explained that part of that instability was caused not because private banks were free to issue currency (even as late as 1907) but because the government maintained a policy of rewarding irresponsible behavior by rescuing financial institutions when they reached the verge of collapse. In any case, as Milton Friedman wrote, the instability of the pre-Federal Reserve years was nothing compared to the booms and busts caused by the monetary authorities after 1913.

To be specific, Milton Friedman blamed the Great Depression on stupid policy by the Federal Reserve. But not stupid inflationary policy, stupid deflationary policy. And that was seventy years ago. We haven't had any Great Depressions then; the Fed seems to have learned its lesson. On the contrary, economic performance has been pretty satisfactory. Of course, we might have done even better without the Fed. It's implausible to interpret 20th-century US economic history as a cautionary tale.

Nobel laureate Friedrich Hayek, whose free-market ideas triumphed with the collapse of the Soviet Union, frequently denounced the connection between central banks and the boom-bust cycle. In an interview conducted in 1977, he said, "If it were not for government interference with the monetary system, we would have no industrial fluctuations and no periods of depression. ... The mistake is the creation of a semi-monopoly where the basic money is controlled by the government. Since all the banks issue secondary money (in the form of loans based on deposits), which is redeemable in the basic money, you have a system which nobody can control."

In many countries, money used to be in private hands (think House of Rothschild). The fact that money was issued by private institutions in part accounts for the extraordinary prosperity that Argentina enjoyed in the 19th century.

In a system of free banking, institutions that do not protect the value of the currency simply collapse -- and their collapse does not wreck the entire economy. Under a rule of law that punishes fraud and counterfeiting, the risk of failure without bailouts is enough to guarantee a more stable system. And in such a system, it would be harder for the government to spend as much money as it does now -- a major factor in the devaluation of the dollar -- because it could not create money, only tax and borrow.

Advocating the abolition of the Federal Reserve, an institution people take for granted, seems too radical for most people, who think financial crises are the result of too little, not too much, government regulation.

I think this line of thought, the position that even money creation should be a private function, is called free banking. Llosa's argument for it is hardly convincing. People have differences preferences with respect to inflation. He seems to be eccentrically and groundlessly extreme in his opposition to inflation, and cantankerously unwilling to consider that others might not regard the mild inflation we have experienced in the past 25 years, or perhaps even a slightly higher rate of inflation that might be in store for us in the next few years, as a serious harm.

The truth is that no one really knows how a free banking system would work. Yes, we sort of had it in the 19th century, and it's very questionable that it was more stable. Llosa cites Argentina, and Argentina did have a great 19th century and a lousy 20th, but it is exceptional in that regard. Anyway, in the 19th century there was the gold standard. A bank could issue notes redeemable in gold, but being on the gold standard was a policy choice. It has been persuasively argued that the gold standard was the reason the Great Depression became international. Gold is a terrible currency for a growing world economy, because the supply of gold has natural limits and can't track the expansion of the need for currency, so there has to be either steep deflation or continuous increase of the money multiplier. It has been persuasively argued that the gold standard was the key factor in deepening, prolonging and spreading the Great Depression.

But what if we allowed Visa, MasterCard, etc., not to print notes based on promises of gold, but to print, in effect, fiat money, whose value they themselves were responsible for maintaining and defending? What would happen if we privatized the dollar, selling the right to print the dollar to whatever consortium of banks won a fair auction, and allowed other firms to issue competing currencies at will? What would be the dynamics of the currency market under free banking? Nobody knows. There are no historical examples. I don't think anyone really knows how to model it. With the new agent-based computational techniques it might be more doable now. It's possible that Hayek and Llosa are right, and that the Fed and its money are distortionary in ways that nobody understands because we don't know anything else. If so, it would be fascinating to find out.